Auvila Flash (05/30/2018): FERC/DOJ support IL nuclear subsidies; Favor EXC in overall long IPP strategy

Contrary to what we thought would happen, the FERC and the DOJ filed a (amicus) brief with the 7th Circuit of the US Court of Appeals in support of IL’s Zero Emissions Credits or ZECs
In the brief, attorneys for the FERC and DOJ argued that unlike the MD program that was struck down by courts, the ZECs do not require nuclear plants in IL to participate in MISO and PJM capacity markets
This is in contrast to the MD program …

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EXC 1Q2018 Earnings (05/02/2018): EXC on pace to beat guidance and benefit from accelerating economy

We feel EXC is well positioned to benefit from accelerating economy. We feel accelerating economy would boost power and natural gas demand, boosting margins through both heat rates and commodity prices.
EXC valuation implies NT growth rate at about negative-1.34% (at midpoint of 2018E AEPS guidance), which we feel is obviously wrong and in gawky contrast to CAGR in utility AEPS expected at 6%-8% and rate base growth at some 7.4% thru 2020.
1Q2018 results didn’t change our thesis that EXC’s endgame is to create optionality for ExGen
Key to this strategy is to ensure ExGen cash flow, which drives need for very high hedging levels far in advance.
The plan also requires EXC to continually make timely regulatory filings to ensure returns consistent with authorized ROEs
We believe that EXC’s next major acquisition would continue in the utility space
We still believe that legal challenges to zero emissions credits (ZEC) in NY and IL will prevail, because ZECs do distort pricing in wholesale markets by increasing supply that otherwise would not be economic
EXC reported $0.96 in AEPS vs. our $0.94 and $0.91 consensus

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EXC 4Q2017 Earnings (02/07/2018): We agree with management’s valuation frustration

We feel EXC is well positioned to benefit from accelerating economy. We feel accelerating economy would boost power and natural gas demand, boosting margins through both heat rates and commodity prices.
EXC also set 2018 AEPS guidance at $2.90-$3.20, about 17% over 2017A AEPS.
Yet, EXC valuation implies NT growth rate at about negative-2.24% (at midpoint of 2018E AEPS guidance), which we feel is obviously wrong and in gawky contrast to CAGR in utility AEPS expected at 6%-8% and rate base growth at some 7.4% (increased from 6.5%) thru 2020.
EXC intends to boost CAGR in dividends to 5% from 2.5%.
4Q2017 results didn’t change our thesis that EXC’s endgame is to create optionality for ExGen.
We’re puzzled why higher rate base CAGR guidance didn’t translate into higher AEPS CAGR guidance.
ST-Target remains at $55/share; NIV/share goes up to $102 from $90 mostly due to Tax Cut and Jobs Act

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2018 Industry Update: Economic growth should favor commodities-driven businesses in 2018

Warmer than normal winter:
Weak gas prices:
However, 4Q2017 and 1Q2018 power gross profit could be better than expectations:
Similarly, we’d expect natural gas infrastructure businesses to perform well for 4Q2017 and 1Q2018:
We expect economic growth to surpass 4% for 2018:
Strong economic performance should lead to strong power sector performance:
Commensurately, we expect natural gas infrastructure businesses to perform well:
Adjusted for seasonality, we expect natural gas prices to creep up throughout 2018 and, given normal weather, we’d expect natural gas prices to average at or just below $3.50 for 2018 with an exit price of some $3.65-$3.75:
Conclusion: Going into 2018, we believe that natural gas prices will stage a moderate recovery, but power margins should do better benefiting from accelerating economic activity. Individually, we continue to like… . However, the real star may be … . Among the utility names, we like … due to their growth prospects. We also look for … to outperform as … .

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GOP Tax Bill is win for utilities, power, infrastructure, and customers

GOP Tax Bill (GOPTB) looks to be positive for industries and companies in our coverage universe
Key aspects of GOPTB that affect our coverage industries and companies include, but not limited to:
21% corporate tax rate would be expected to reduce deferred income tax liability by some 40%
Interest expense deductibility capped at 30% of EBITDA for 2018-2021 and to 30% of EBIT after
100% investment deduction, except for utilities that would continue to deduct 100% interest
Preservation of existing investment tax credits (ITC) and production tax credits (PTC)
Repatriation of profits tax at 15.5% for cash and equivalent and 8% for non-liquid assets
Base-erosion & Anti-abuse Tax (BEAT) not impactful: If payments to foreign affiliates are 3% or more of a large company’s tax deductions then BEAT is imposed. We do not view this as relevant to companies that we cover, given 100% of PTC would be allowed to offset up to 80% of BEAT
AES Corp. faces large disqualification of interest expense deductibility but given its $3.7B in NOLs, we do not believe this to be an immediate issue; AES has time to remedy the situation:
NRG Energy shouldn’t have any issues with interest expense deductibility:
Exelon Corp. isn’t expected to have any problems with interest expense deductibility:
Cheniere Energy, oddly enough, shouldn’t have any problems with interest expense deductibility:
BKH, CNP, DUK, EIX, PCG, PNM, SRE should not have any issues with interest expense deductibility but may be able to use 100% investment deductibility to create win-win:
We note that the inability to deduct interest expense is limited to $0.21/$1 of lost deductibility
Loss of interest expense deduction could lead to some unexpected corporate behavior

Conclusion: Net effect of GOPTB looks to be positive, more so if utility holding companies are permitted to use non-utility subs to take advantage of the 100% capital investment deduction

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EXC 3Q2017: Upside from FERC redesign of power pricing may boost EXC by 36%

3Q2017 results and earnings call didn’t change our thesis that EXC’s endgame is to create optionality for ExGen
To do so, we believe that EXC plans to use ExGen cash flow to propel Utilities’ CAGR in AEPS at some 6%-8% through 2020, while lagging dividend CAGR at 2.5%, allowing Utilities dividend payout to go from almost 100% to about 77%, making it possible for Utilities to self-fund equity needs beyond 2020
Key to this strategy is to ensure ExGen cash flow, which drives need for very high hedging levels far in advance
We look for EXC to expand its Retail business, curtail its hedging program commensurately, and potentially take a more open position
The plan also requires EXC to continually make timely regulatory filings to ensure returns consistent with authorized ROEs
We believe that EXC’s next major acquisition would continue in the utility space
EXC has upside from resiliency pricing, if FERC gets there.

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EXC 2Q2017 Earnings Note: Regulatory filings continue; strong execution; valuation compelling

Regulatory filings continue; strong execution; valuation compelling || 2Q2017 results and earnings call did not add any to or take away from our thesis that EXC’s endgame is to create optionality for ExGen. To do so, we believe that EXC plans to use ExGen cash flow to propel Utilities’ CAGR in AEPS at some 6%-8% through 2020, while lagging dividend CAGR at 2.5%. allowing Utilities dividend payout to go from almost 100% to about 77%, making it possible for Utilities to self-fund equity needs beyond 2020. This then creates ExGen optionality for EXC, in our opinion. Key to this strategy is to ensure ExGen cash flow, which drives need for very high hedging levels far in advance. However, given liquidity issues in hedging market, we look for EXC to expand its Retail business, curtail its hedging program commensurately, and potentially take a more open position, taking advantage of its strong financial position. The plan also requires EXC to continually make timely regulatory filings to ensure returns consistent with authorized ROEs. We believe that EXC’s next major acquisition would continue in the utility space. Despite court results in NY and IL, we are still of the opinion that legal challenges to zero emissions credits (ZEC) in NY and IL will prevail, because ZECs do distort pricing in wholesale markets by increasing supply that otherwise would not be economic.

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The Logic NY Fed Court Decision to Uphold ZECs is Spurious

The US District Court of the Southern District of New York (Fed District Court) yesterday ruled through New York Southern District Judge Valerie Caproni dismissed all challenges to New York’s Zero Emissions Credit (ZEC) program
The decision by Judge Caproni, though seemingly logical, is actually spurious, in our opinion. The decision was based on the following logic and comparison:
While we do appreciate Judge Caproni’s position and interpretation of the law, we note several inconsistencies in the Judge’s arguments

By acknowledging that financial subsidies do allow otherwise uncompetitive sources of generation to be built, Judge Caproni is acknowledging that financial subsidies do distort market pricing because it increase supply into the market relative to demand, which by definition, ALWAYS NEGATIVELY affects pricing

Conclusion: Therefore, we continue to believe that as the case is appealed to higher judicial authority, we maintain that the most rational outcome is the reversal of both NY and IL subsidies for nuclear power. However,

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Power Company Privatization will Lead to Unintended Consequences

Lately there has been talk about privatizing power companies, including both CPN and NRG, and while we believe that the most rational course for these companies may be to go private – given the lack of “enthusiasm” for these names in the public markets – we are certain that the end result will not be either what the market expects nor what the regulators, politicians and, most of all, what the consumers desire
The assumptions we are making in our analysis are as follows:
Private equity (PE) investors are not unintelligent and will act in their own self-interest
Virtually all of the market (public and private) believe in the theory of “all else being equal”
Market forces move along least resistant path absent paradigm shift, typically externally imposed
As reserve margins dip below 12% market prices become more volatile and margins begin to expand at an accelerated rate
PE investors will be betting on the reduction of debt from internally generated free cash flow and asset sales, supplemented by cost reductions, to increase the equity value of its investments with the option value of changing market dynamics to further boost its rate of return
The first thing that PE investors are likely to do is to make the assumption that the underlying market forces and conditions don’t/can’t/won’t change for the foreseeable future
Based on these underlying assumption, PE investors will be able to figure out which plants they buy will remain profitable, which won’t and which are on the margin

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EXC 1Q2017 Earnings Note

Regulatory steps brighten prospects while ExGen continue to languish ||

We continue to believe EXC’s endgame is to create optionality for ExGen. To do so, EXC plans to use ExGen cash flow to propel Utilities’ CAGR in AEPS at some 6%-8% through 2020, while lagging dividend CAGR at 2.5%. This allows Utilities dividend payout to go from almost 100% to about 77%, making it possible for Utilities to self-fund equity needs beyond 2020, negating need for ExGen ATM, which then creates ExGen optionality for EXC, in our opinion. Key to this strategy is to ensure ExGen cash flow, which drives need for very high hedging levels far in advance. This sacrifices upside potential and sub-optimizes ExGen, but enables EXC to execute its LT plan. This plan also requires EXC to continually make timely regulatory filings to ensure returns consistent with authorized ROEs. This plan may also change what EXC pursues next, which we believed would be another hybrid. Instead, it may pursue pure utilities. Still we’d like EXC to buy nuclear, gas and renewable plants, while cheap, so we like EXC’s purchase of Fitzpatrick nuclear plant in NY. Regardless, we like EXC’s plans for Utilities and believe it will eventually help drive upside valuation, and reluctantly support ExGen strategy. We are of the opinion that legal challenges to zero emissions credits in NY and IL will prevail.

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